Is an Angel a fool?

In the world of private equity investing, the order of funding is supposed to go like this:

Seed Round—that’s friends, family, and fools.

Angel Round—that’s funding the big initial spurt of growth.

Venture Round—that’s big funding for massive scaling.

Compare that stack-of-three (above) to a peanut butter and jelly sandwich. Notice that Angels make up the good stuff in the middle. And yes—according to studies by the Kauffman Foundation—Angels make the best money.

But sometimes Angels step in early—right next to friends and family. Sometimes they get in late—right next to VCs. That’s the PB&J squeezing out the sides of the bread.

We all know the friends and family round is the most likely to fail and we shoulda oughta shy away from it. But if we wait too long we ain’t makin’ no money. According to research by the Kauffman Foundation, investors in VC funds on average make a NEGATIVE return. That’s right—average negative. Angels do a whole lot better. So maybe it’s wise to avoid the sloppy edges. Make sense so far?

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The Basic Question

In investing, the exercise always boils down to this: Here’s the environment—how do we make money in it? Investors always look for an edge—some slight advantage over the masses. And there definitely is an Angel Edge. Let’s examine:

Angel investing is entirely non-correlated to the broader security markets. (Hey, if you got a stock portfolio to protect, that’s a big deal.)

An Angel’s potential return—on average—knocks the stuffing out of traditional securities. (Again, that’s according to research from Kauffman.)

Then there’s the intellectual exercise. (Let’s face it, that’s a reward in itself. Otherwise we’d all turn our money over to some manager or mutual fund.)

Then you sometimes get to roll up your sleeves and sit on the board of one or more companies, which can be a real blast. (Beats sucking on an umbrella drink on some tropical beach. At least I feel that way. I sunburn so easily.)

So the Angel route makes for an enticing package. But it’s not for everybody. Then there’s my general attitude: I’m always suspicious of enticing packages. So let’s take a peek at the risks and rewards.

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Risk

It is well known that private equity investing carries with it a high risk compared to stodgy investments like stocks or treasuries. (Treasuries pay close to zero these days). Rather than buying regulated marketable securities in all-too-efficient markets, an Angel negotiates terms and makes private deals. Anything can happen. Let’s identify a few of the risks:

No liquidity

No stop loss

Little diversification (That is, if you’re a lone wolf. More on that below.)

Long time horizon

An Angel typically waits 3-5 years or more to cash out. Hey, I come from the world of 1-7 days and out—MAX. To me, anything measured in years is a real long time. But 3-5 is a short time compared to Venture Capital. It’s short compared to starting your own venture. It’s real short compared to real estate.

Reward

There are a number of advantages that attract money to this model:

Larger average payoffs compared to investing in securities. (More on this in the next issue.)

The chance to buy a future Industry Giant at a very early stage. (If you do enough deals and perform your due diligence, that might actually happen.)

As mentioned, private equity is non-correlated to the broad markets, like stamp collections or antique cars. (That means you might make money, even when the broad markets tank.)

Let me explore that last bullet a bit deeper: This is an Alternative InvestmentVehicle. Alternative investments tend to be high-risk. But as part of a larger portfolio they can—(and this is non-intuitive)—can INCREASE return and REDUCE overall risk. Nice combination, don’t you think?

This strange phenomenon is mathematically demonstrated on a graph called The Efficient Frontier. It takes some thought to set up the strategy, and don’t overdo it. Conventional wisdom is to limit alternative investment to less than 10-15% of a total portfolio.

Risk Mitigation

How do you raise your returns above the averages, yet control risk? Skill, knowledge, and raw instinct? Personally, I don’t harbor such fantasies—I believe that it’s better to belong to a group. As a member of an Angel group, you enjoy a number of advantages that reduce risk:

Diversification – To throw all your capital into just a couple ventures is clearly dangerous. Members of a group can spread their deals across a large number of companies.

Industry Knowledge – A strong Angel group includes experts, in various industries. What single individual can boast deep knowledge of more than one or two industries?

Expertise – Members come from various disciplines—Finance, Accounting, Marketing, Operations, Science, Engineering. Who holds diplomas in all those areas?

Workflow – Many hands make for light work.

Control – When you play the stock market, you exercise HOPE. In contrast, an Angel group may have a member sitting on the Board of Directors.

Let’s Review

This is an Alternative Investment. Keep it small compared to the overall portfolio.

CAVEAT EMPTOR – This article is for educational purposes and is not investment advice. All investment involves substantial risk. Please do your due own diligence. Contact Ron Kirschner – Ron@HeartlandAngels.com

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